Risk Distribution in the Capital Markets: Credit Default Swaps, Insurance and a Theory of Demarcation

Goldman [Sachs] should matter to outsiders . . . because it stands at the centre of a two-decade-long transformation of the financial markets and a new approach to risk. Business risks that were once seen as a lumpy fact of life are now routinely sliced up and packaged into combinations that generally suit issuers and investors alike. At the heart of this change has been the development of huge markets in swaps, derivatives and other complex and often opaque instruments that allow the transfer of risk from one party to another. From small beginnings in 1987, the face value of contracts in interest-rate and currency derivatives is now more than $200 trillion[,] 16 times America's GDP. A further $17 trillion is outstanding in (even newer) credit-default swaps, which allow bond investors to lay off the risk of issuers defaulting. I. INTRODUCTION Heralded as the "debutante of the suretyship world (pure as the wind-driven snow and virtually unsullied by the foul touch of litigation)," credit default swaps (CDS) have transformed banking.2 Lenders who once found themselves stuck with bundles of indivisible, illiquid risks can now carve out and hedge credit exposure to individual borrowers. And they do it on a massive scale. As last reported by FitchRatings, the notional amount of outstanding CDS stood at $3.5 trillion, representing two-thirds of the entire credit derivatives market and an 86% increase from the prior year's total of $2.8 trillion.3 Yet despite such rapid growth, use of credit derivatives was too small to be either noticed or recorded at any significant levels in 1996.4 As one would expect of a market that has gone from cradle to world phenomenon in less than a decade, CDS have attracted both supporters and detractors. Proponents extol the ability of CDS to spread risk and increase liquidity across credit markets, allowing participants to actively manage and protect credit portfolios.5 Sensational critics warn that a spike in interest rates could trigger a "derivatives tsunami" that would bring all of the major banks to their knees and cause a "blowup" in world credit markets.6 Experience in the past few years has shown that, if used responsibly, CDS have the ability to yield all of the promised benefits with few-if any-of the predicted catastrophes.7 Between the disparagers and the defenders of CDS stand the regulators. But who are the regulators of CDS markets, and what law applies? Since CDS are traded entirely over-the-counter (OTC), one could argue that the true regulators are market participants themselves. Banded together as members of the International Swaps and Derivatives Association (ISDA), derivatives markets participants have created a system of documenting and amending trade relationships that is both flexible and robust. Most members of ISDA are banks or groups of banks. Some outside regulators, however, worry that CDS markets are growing too quickly for any bank or group of banks to control.8 In judging who has authority to step in and govern various aspects of CDS trading, one confronts a crowd of would-be regulators. The CFTC, SEC, Fed, state insurance regulators, and both state and federal courts all have spheres of competence that, depending on circumstances, may or may not affect CDS trading. Letters of guarantee and other analogous surety instruments require their users to focus on merely one body of statutory law-e.g., Article 5 of the Uniform Commercial Code-and its applicable case precedents; CDS, on the other hand, demand that their users at least take account of (and perhaps apply) commodities, securities, banking, and insurance regulation, as well as all applicable case law. Where commodities regulation is concerned, CDS enjoy a blanket exemption under the Commodities Exchange Act.9 The Commodities Exchange Act (the "Act") includes in its definition of "excluded commodity" any "credit risk or measure."10 Building on this definition in a section on "excluded derivative transactions," the Act notes that its terms do not apply to any agreement in an excluded commodity where such agreements are executed between eligible participants-financial institutions, regulated insurance companies, and most investment companies-off of a registered exchange. …